This paper explores the factors that have led to a Canada-U.S. productivity gap using a sectoral growth accounting approach. Both fiscal and monetary policies have had significant effects on the saving rate. The Canadian dollar’s appreciation was followed by a protracted period of exchange rate weakness. This paper reviews the institutional aspects of Canada’s real return bond program. The Canadian system provides a successful model for pension reform. Free trade has helped promote the integration of U.S. and Canadian economies, but significant differences remain.

Abstract

This paper explores the factors that have led to a Canada-U.S. productivity gap using a sectoral growth accounting approach. Both fiscal and monetary policies have had significant effects on the saving rate. The Canadian dollar’s appreciation was followed by a protracted period of exchange rate weakness. This paper reviews the institutional aspects of Canada’s real return bond program. The Canadian system provides a successful model for pension reform. Free trade has helped promote the integration of U.S. and Canadian economies, but significant differences remain.

VI. Canada-U.S. Economic Integration: Developments and Prospects1

1. Important milestones have been reached this year in the history of bilateral economic relations between Canada and the United States. In particular, 2004 marks the 10th anniversary of the North American Free Trade Agreement (NAFTA) and the 15th anniversary of its precursor, the Canada-U.S. Free Trade Agreement (CUSFTA). These agreements have been exceptionally successful in promoting trade and financial flows between the two countries over the years, yielding one of the world’s largest bilateral trade and bilateral direct investment relationships (USTR, 2003).

2. Some observers have recently called for deeper integration with the United States in order to eliminate remaining barriers to trade. The most ambitious proposals include calls for a “grand bargain,” which would couple security and defense-related policies with deeper trade integration, possibly in the context of a customs union or common market (Dobson, 2002). Similarly, some proposals have included calls for a monetary union with the United States (Courchene, 2003).2 However, more modest and immediately practical proposals have also been made, involving suggestions for greater effort toward harmonizing rules, standards, and regulations, in order to reduce the extent to which these arrangements impede trade and efficiency (Goldfarb, 2003).

3. This chapter analyzes the impact of the major Canada-U.S. trade agreements on trade and business cycles to shed some light on the debate about the future direction of economic integration. The chapter first reviews the key provisions of these agreements. Then, it examines their impact on trade and financial flows and shows that there has been a substantial increase in trade and financial flows between the two countries after the inception of CUSFTA.3 Next, the extent to which there has been an effect on the comovement of Canada-U.S. business cycles is studied. The chapter concludes by arguing that while economic integration has been associated with a significant increase in business cycle synchronicity, the United States and Canada remain subject to substantial country-specific shocks. Although these results would seem to weigh against moves toward a monetary union, the still significant integration between the two countries suggests significant benefits could be reaped from further reducing other barriers to trade.

A. Trade Agreements Between Canada and the United States

4. An important step toward promoting Canada-U.S. trade linkages was the 1965 Canada-U.S. Auto Pact. Prior to the Auto Pact, tariffs on cross-border trade in automotive products were high—roughly 7½ percent in Canada and 17½ percent in the United States. The Pact eliminated all tariffs faced by producers and led to a significant growth in the Canadian auto industry—the industry became highly integrated with the U.S. industry and transportation equipment became Canada’s largest export to the United States.

5. The 1989 Canada-U.S. Free Trade Agreement (CUSFTA) introduced free trade in almost all sectors. CUSFTA eliminated most tariffs and other trade barriers in its first ten years, with the average Canadian tariff on manufacturing imports from the United States falling from 3 percent in 1989 to almost zero in 2001, and the average U.S. tariff on imports from Canada falling from around 4.5 percent to 0.5 percent during the same period (Figures 1 and 2). The agreement gave considerable preferential tariff advantage to the other country, since tariffs on imports from third countries remained relatively higher. In addition, CUSFTA substantially reduced nontariff barriers, provided ground rules covering trade in services and investment, and included various dispute settlement mechanisms.

Figure 1
Figure 1

United States: Average Tariffs on Imports from Canada and World

Citation: IMF Staff Country Reports 2004, 060; 10.5089/9781451806908.002.A006

Figure 2
Figure 2

Canada: Average Tariffs on Manufacturing Imports from the U.S. and Rest of World

Citation: IMF Staff Country Reports 2004, 060; 10.5089/9781451806908.002.A006

Source: Fund staff calculations.

6. The 1994 North American Free Trade Agreement (NAFTA) represented a further milestone. NAFTA expanded various provisions of CUSFTA and broadened the scope of the agreement by including Mexico (Hufbauer and Schott, 1992, and USITC, 2003). It eliminated the majority of tariffs and other trade barriers in its first ten years and will have phased out most remaining tariffs by 2008. Moreover, building on the provisions of CUSFTA, NAFTA included various provisions covering investment flows, financial services, government purchases, and protection of intellectual property rights.

7. In addition, NAFTA introduced unique mechanisms for settlement of disputes and included side agreements covering labor and environmental issues. In particular, NAFTA established processes dealing with various issues including appeals of antidumping and countervailing duty determinations; resolution of investor-state disputes; and private commercial disputes. NAFTA included two important side agreements: the North American Agreement on Labor Cooperation, aimed at promoting enforcement of domestic labor laws; and the North American Agreement on Environmental Cooperation, established to ensure that trade liberalization and environment goals were mutually supportive.

B. Growth of Trade and Financial Flows

8. Trade flows between Canada and the United States increased significantly after the advent of CUSFTA. Canada’s merchandise trade (the sum of exports and imports) to the United States more than doubled in U.S. dollar terms over the period 1988-2002, rising from around 30 percent of GDP to as high as 55 percent of GDP (Figure 3a). By 2002, roughly 90 percent of Canadian merchandise exports were directed to the United States, a 17 percentage point increase from 1988 (Figure 3b). By contrast, the share of Canadian imports from the United States remained roughly unchanged at around 65 percent during the same period.

Figure 3
Figure 3

Canada and the United States: Trade Linkages

Citation: IMF Staff Country Reports 2004, 060; 10.5089/9781451806908.002.A006

Source: DFAIT (2003); and Fund staff calculations.

9. The product mix of Canada-U.S. trade also shifted. Although transportation equipment along with machinery and electronics continued to represent a significant fraction of Canada’s total trade with the United States, their importance decreased during the period 1989-1992 (Table 1). Notably, the share of Canada’s exports to the United States associated with primary sectors, including metals and minerals and wood and pulp, also declined somewhat, with sharp increases in apparel and textiles and special transactions (DFAIT, 2003). These trends were accompanied by a significant increase in the share of Canada’s exports from the agriculture and oil sectors, and to a lesser extent, the manufacturing and service sectors being directed to the United States (Figure 3c).

Table 1

Canada: Merchandise Trade with the United States

(Share of total exports and imports in percent)

article image
Source: DFAIT (2003).

10. The inception of CUSFTA also had important national and regional effects in Canada. With exports to the United States rising much faster than imports, the contribution of net exports to GDP growth jumped from about zero during the period 1973-1988 to about 0.75 percentage points after the introduction of CUSFTA (Figure 3d). The growth in trade appeared to favor those regions—British Columbia, the Prairies, and the Atlantic region—which previously had relatively weak ties to the U.S. market (Figure 3e). These regions saw a sharp jump in the share of their exports being directed to the United States, narrowing the gap with Ontario and Quebec, which had already enjoyed strong trade links to the United States (Figure 3f).4

11. Recent research confirms the significant impact of CUSFTA on Canada-U.S. trade flows. Clausing (2001) analyzes the effect of CUSFTA on commodity-level tariff rates and concludes that more than half of the increase in Canada’s exports to the United States during 1989-1994 was due to the agreement. Romalis (2002) also confirms that CUSFTA has had a large impact on Canada’s trade share with the United States. Schwanen (1997) compares trade in sectors that were liberalized after CUSFTA and NAFTA with others and concludes that exports of Canada to the United States in these sectors rose by 139 percent and by only 64 percent in other sectors.5

12. Canada’s trade appears to have become more geared toward manufactured goods as a result of the boom in Canada-U.S. trade linkages. The share of manufactures in total exports rose from less than 33 percent in 1960 to roughly 63 percent in 2001, with a correspondingly less prominent role played by agriculture and fuels (Table 2). The share of manufacturing imports also increased from less than 70 percent in I960 to roughly 83 percent in 2001.

Table 2

Canada: Composition of Trade

(Share of total exports and imports in percent)

article image
Source: World Bank, World Development Indicators.

13. Trade liberalization has also spurred cross-border vertical integration. For example, the share of Canada’s exports based on vertical trade—i.e., the share of export value that is due to the processing of imports at an earlier stage of production—rose by twofold since the inception of CUSFTA (Figure 4). Dion (1999) finds that there has been a dramatic increase in vertical specialization across manufacturing industries especially since the late 1980s (which coincides with the inception of CUSFTA).6 Hummels, Rapaport, and Yi (1998) conclude that the 1965 U.S.-Canada Auto Agreement led to a substantial increase in vertical trade in auto industry.

Figure 4
Figure 4

Vertical Specialization

Processed Imports as a Share of Sectoral Merchandise Exports

Citation: IMF Staff Country Reports 2004, 060; 10.5089/9781451806908.002.A006

14. Trade liberalization has also been associated with a significant increase in foreign direct investment (FDI) flows between Canada and the United States. Gross FDI flows increased by more than sevenfold between 1989 and 2002, with similar increases in both directions (Figure 5). The bulk of the FDI inflows to Canada came from the United States as the average share of inflows from the United States accounted for 68 percent of total inflows over the period 1989-2002. A tremendous increase in FDI flows occurred after the inception of NAFTA, associated with a small number of mega-mergers (DFAIT, 2003).7 As a result, the average share of FDI inflows in Canada’s domestic gross fixed capital formation (investment) rose from 6 percent in the 1986-1988 period to 26 percent over the 2000-2002 period.

Figure 5
Figure 5

Canada-U.S. FDI Flows

Citation: IMF Staff Country Reports 2004, 060; 10.5089/9781451806908.002.A006

Source: Fund staff calculations.

C. Changes in Business Cycle Dynamics

15. In theory, increased trade linkages have ambiguous effects on the comovement of business cycles. Stronger trade linkages can result in more highly correlated business cycles by increasing demand- and supply-side spillovers. Increased intra-industry specialization across countries can also increase cyclical comovement, if industry-specific shocks are important in driving business cycles. However, the degree of comovement might fall if inter-industry (rather than intra-industry) trade linkages are spurred and industry-specific shocks are important in driving business cycles (Kose and Yi (2001)).

16. The effect of financial flows on business cycle correlations also depends on the nature of shocks and specialization patterns. For example, stronger financial linkages could generate higher cross-country synchronization of output by allowing easier spillovers of demand-side shocks. However, financial linkages could help facilitate investment and specialization of production, thereby increasing countries’ exposure to industry- or country-specific shocks. This could lead to a decrease in the degree of output correlations while inducing stronger comovement of consumption across countries (Kalemli-Ozcan, Sorensen, and Yosha (2003)).

17. These competing factors complicate evaluations of the impact of trade agreements on Canada-U.S. business cycles. The increase in vertical specialization and intra-industry trade between Canada and the United States would typically be expected to strengthen business cycle linkages over time. However, inter-industry trade and differences in industrial structure are still considerable, implying that sector specific shocks could lead to divergence of cycles. For example, the fact that Canada experienced a shallower downturn and a relatively stronger recovery from the 2000 recession than the United States has often been ascribed to Canada’s smaller IT sector, as well as to the effects of a relatively depreciated exchange rate and the improvement in global commodity prices.

18. Recent empirical studies are inconclusive regarding the extent to which business cycles in the two countries have become more synchronized. Kose, Prasad, and Terrones (2003, 2004), Kose, Otrok, Whiteman (2004) and Stock and Watson (2003) find that the importance of global factors in explaining business cycles in both countries has risen since the 1980s and conclude that business cycle linkages between Canada and the United States have become stronger over time. By contrast, Doyle and Faust (2003) show that there has been no statistically significant change in the correlations of the growth rates of GDP of Canada and the United States since the 1960s, with similar results reported by Helbling and Bayoumi (2003). Heathcoate and Perri (2003) show that the U.S. business cycle has become less correlated with the aggregate cycle of Europe, Canada, and Japan since the 1960s.

19. Inspection of simple correlations suggests an increase in the comovement of business cycles in Canada and the United States. For example, an increase is clearly evident in the 20-year rolling correlations in cyclical deviations of Canada’s output, consumption, and investment and cyclical deviations in the United States, with a particularly sharp increase in the case of investment and imports after the inception of CUSFTA (Figures 6 and 7). At the same time, the Canadian and U.S. business cycles have become less correlated with cycles in other G-3 countries (Germany and Japan).

Figure 6
Figure 6

Canada and the United States: Comovement of Economic Variables

Citation: IMF Staff Country Reports 2004, 060; 10.5089/9781451806908.002.A006

Source: Fund staff calculations.
Figure 7
Figure 7

Canada and the United States: Comovement of Economic Variables

Citation: IMF Staff Country Reports 2004, 060; 10.5089/9781451806908.002.A006

Source: Fund staff calculations.

20. In order to better identify the source of this apparent increase in convergence of business cycles, a dynamic latent factor model is estimated. The model (employed in Kose, Otrok, and Whiteman, 2003) allows estimation of the extent to which common or country specifics factors explain the changes in the comovement, and also help take into account potentially important “leads” and “lags” in the cross-correlation of different macroeconomic variables.

21. The model focuses on the dynamic comovement of output, consumption, and investment across Canada and the G-3 countries. It decomposes macroeconomic fluctuations into (i) a “common” factor that is common across all variables/countries; (ii) “country-specific” factors, which are common across the main aggregates within a country; and (iii) “idiosyncratic” factors, which are specific to total output, consumption, and investment (idiosyncratic errors). In particular, there are three types of factors in the model: the common factor (fcommon), four country-specific factors (ficounttry, one per country), and 12 factors specific to each variable i, t, the “unexplained” idiosyncratic errors). Observable variables are denoted by yi, t, for i= 1,...,12, and t=1960Ql-2002Q4. Thus, for observable i:

yit=ai+bicommonftcommon+bicountryfn,tcountry+ɛi,tEɛi,tɛj,ts=0forij,

where n denotes the country number. Output, consumption and investment data for each of four countries are used as observables, so there are 12 time series to be “explained” by the five factors and 12 “regression” equations to be estimated.

22. The estimation results suggest that the common factor played an important role in explaining business cycles since the 1960s. For example, casual observation suggests that the common factor has been an important force behind most of the major business cycle episodes of the past 40 years. In particular, the behavior of the common factor is consistent with the steady expansionary period of the 1960s, the boom of the early 1970s, the recessions of the mid-1970s, the early 1980s and 1990s, the expansionary period of the late 1980s, and the global downturn of 2001-2002 (Figure 8a). At the same time, the Canada-specific country factor was also important in explaining some of Canada’s major cyclical episodes, including the recessions of 1982 and 1991, the economic slowdown in 2001, and the booms of the 1960s, and the second half of the 1990s (Figure 8b). Indeed, while the common factor has been important, it explains only about 10 percent of Canada’s output volatility, with the country and idiosyncratic factors explaining the bulk of the volatility for the period 1960Q1-2002Q4 (Figure 8c). By contrast, the common factor is relatively more important in Germany and Japan, explaining more than 25 percent of output volatility in Japan.

Figure 8
Figure 8

Dynamic Factor Model: Factors and Variance Decompositions

Citation: IMF Staff Country Reports 2004, 060; 10.5089/9781451806908.002.A006

Source: Fund staff calculations.

23. However, the common factor has played an increased role in explaining business cycles in Canada and the United States since the early 1980s. Comparing estimates of the model calculated over two separate sub-periods—1960Q1-1981Q2 and 1981Q3-2002Q4—shows that the share of Canada’s output variance explained by the common factor roughly tripled in the later period (Figure 8d). Moreover, the share of investment due to the common factor rose by fourfold during the second period and the role of the common factor in explaining consumption variance increased from less than 5 percent to roughly 40 percent (Figures 8e and 8f). Although the importance of the common factor also increased for the United States, the increase was smaller than that for Canada.

24. Nonetheless, country specific and idiosyncratic factors remain important in Canada. The country-specific factor still accounted for more than 10 percent of volatility of each variable in the second period, and the majority of business cycle variation is still attributed to the idiosyncratic factor (Table 3). The country-specific and idiosyncratic factors also explained over 50 percent of business cycle variation in the United States.

Table 3

Variance Decompositions

(In percent)

article image
Notes: 33% and 66% refer to the confidence intervals of the median.Source: Fund staff calculations.

25. By contrast, the common factor became less important in explaining output volatility in Germany and Japan. This likely reflects the relative importance of domestic forces that have swamped the importance of increased trade and financial linkages during the past two decades. The Japanese economy has been struggling with a variety of structural problems as it has suffered from a sharp fall in asset prices and a severe banking crisis since the early 1990s. The German economy has been affected by the aftershocks of unification during the same period. In addition, the share of trade with these two countries has decreased in both Canada and the United States during the 1990s.8

D. Concluding Remarks

26. The results above illustrate that while free trade has helped promote the integration of the U.S. and Canadian economies, significant differences remain. Business cycles in Canada and the United States have certainly become more synchronized, and the importance of common factors in explaining business cycles in the two countries has increased, likely reflecting the significant increase in trade based on vertical specialization. Nonetheless, significant structural differences remain evident from two economies. Primary goods still account for more than 30 percent of Canada’s total exports, and the analysis above shows that country-specific and idiosyncratic factors remain very important in explaining the Canadian business cycle.

27. These remaining differences suggest that there could be gains from further steps to deepening economic linkages. The CUSFTA/NAFTA experience illustrated the significant benefits accruing to both countries from free trade, but important barriers remain. For example, differences in regulatory frameworks impede trade and investment flows; security concerns, which have become critically important during the past two years, slow cross-border flows of goods; and rules-of-origin requirements also restrict trade flows (McMahon, Curtis, and Adegoke, 2003). Recent research suggests that the removal of rules-of-origin requirements and the harmonization of MFN tariffs—which is under discussion among the NAFTA partners—could boost Canada’s GDP by as much as 2-3 percent (Policy Research Initiative, 2003).9

28. The continued importance of country-specific and idiosyncratic factors in driving business cycles in Canada also confirms the benefits of exchange rate flexibility. Although there remain those in Canada who argue in favor of a Canada-U.S. monetary union, the significant differences in industrial structure and composition of trade between the two countries suggest that there could be important costs to Canada giving up its ability to insulate itself from country-specific and other shocks.

References

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1

Prepared by M. Ayhan Kose.

2

Arora and Jeanne (2001) argue that exchange rate flexibility has not slowed the pace of Canada-U.S. economic integration, and has been useful in isolating the Canadian economy from asymmetric external shocks. Murray, Schembri, and St-Amant (2003) also provide evidence in support of exchange rate flexibility.

3

This chapter focuses on the impact of CUSFTA and NAFTA on the Canadian economy. Kose (2003) examines the impact of NAFTA on the Mexican economy.

4

Courchene (2003) emphasizes the growing importance of north-south trade in contributing to provincial GDP growth (especially in Quebec and Ontario) after the inception of CUSFTA. For example, Ontario’s exports to the United States rose from 25 percent of its GDP in 1989 to almost 50 percent in 2001.

5

Trefler (2001) and Head and Reis (2003) also find that CUSFTA appeared to have a positive impact on trade flows. Krueger (1999, 2000) also documents that there has been a substantial increase in trade flows between Canada and the United States after NAFTA. Clausing (2001) concludes that the agreement did not result in any sizeable trade diversion, i.e. the expansion of trade was not at the expense of other countries, while Romalis (2002) argues that the agreements induced substantial trade diversion.

6

Intra-industry trade between Canada and the United States has also increased. However, recent research is unable to establish a clear link between CUSFTA/NAFTA and the increase in intra-industry trade between the two countries during the 1990s (Trefler, 2001, and Acharya, Sharma, and Rao, 2003). The free trade agreements also affected the productivity dynamics in Canada as discussed in Chapter I.

7

Although there was a significant increase in the volume of FDI flows from the United States to Canada in the period 1989-2002, the U.S. share of Canadian FDI stock remained quite stable at around 65 percent. Recent research is unable to show that CUSFTA/NAFTA has had any discernible impact on FDI flows between the two countries (Schwanen, 1997, and Globerman and Shapiro, 2003).

8

There have also been important changes in the dynamics of volatility since the early 1990s. For example, the volatility of Canadian macroeconomic variables has diminished during the 1990s. Debb (2001) finds a statistically significant structural break in the volatility of Canadian real GDP growth in the first quarter of 1991, and others have found similar breaks for the U.S. and the rest of the G7, except for Japan, since the late 1980s.

9

NAFTA partners have recently decided to establish study groups to analyze avenues for harmonization of MFN tariffs and rules of origin requirements, and to improve rules governing investment flows. In addition, recognizing the importance of secure and continuous access to each other’s markets, Canada and the United States have recently placed an emphasis on border security. For example, a Smart Border Action Plan has been implemented, which includes a Free and Secure Trade (FAST) program to harmonize procedures for clearing cross-border shipments.

Canada: Selected Issues
Author: International Monetary Fund